Some costs are paid before the period they belong to, and some income is received before it is earned. A year’s profit should include only the expense and income that relate to that year. The part paid or received early is carried forward, as an asset when it is an expense paid in advance, and as a liability when it is income received in advance.
This topic covers prepaid expenses and unearned income, the two-account and one-account methods, the reversal, and the formula for the figure charged to profit or loss.
Prepayments and unearned income are tested in Section A in most diets and sit inside many final accounts questions. A rental income account with both prepaid and accrued rent appeared as a full part in two diets reviewed. Read accrued expenses and accrued income first, because this topic is its mirror image. The next topic starts the section on property, plant and equipment.
In 30 seconds
A Prepaid expense is paid or invoiced in the period but relates to a later period. It is removed from this year’s expense and shown as a Current asset: with two accounts, Dr Prepayments, Cr Expense, reversed at the start of the next year. Unearned income is received in advance. It is removed from this year’s income and shown as a Current liability: Dr Income, Cr Unearned income.
With one account the balance is carried on the expense or income account and nothing is reversed. Expense = payments + opening prepayment − closing prepayment. Income = receipts + opening unearned income − closing unearned income.
Prepaid expenses
Prepaid expenses are expenses recorded in the current period because an invoice has arrived or a payment has been made, but all or part of the expense relates to a later period. They arise whenever a payment is made in advance.
Under the accruals basis, the part that relates to a future period must be Excluded from this year’s expenses and recognised as an asset at the year end, the prepayment, which is then Included in the expenses of the next period.
For example, Moses insures his office on 1 March for a year at ₦24,000, paid in advance. Ten months fall in Year 1 and two in Year 2 (January and February). The Year 1 charge is 24,000 × 10/12 = ₦20,000 and the prepayment at the year end is 24,000 × 2/12 = ₦4,000, an asset.
Method 1: two accounts
This is the easier method and the one used in computerised systems. The prepayment is transferred from the expense account to a prepayments account.
Dr Prepayments account (an asset), Cr Expense account. The credit reduces the expense recognised, and the debit balance on the prepayments account is a current asset.
At the start of the next year the prepayment is Reversed: Dr Expense, Cr Prepayments. This reinstates the amount as an expense of the second year. In Moses’s Year 2 the premium is ₦30,000 for the year to 28 February Year 3, so the prepayment at the end of Year 2 is 30,000 × 2/12 = ₦5,000. The Year 2 insurance expense is the reversed 4,000 plus the 30,000 paid, less the new prepayment of 5,000, which is ₦29,000.
It is the two months of the old premium (4,000) plus ten months of the new (30,000 × 10/12 = 25,000).
Method 2: one account
The prepayment is recognised on the expense account itself. Either calculate the expense and take the prepayment as the balancing figure, or, usually easier, calculate the prepayment and take the transfer to profit or loss as the balancing figure. The prepayment stays as the closing balance, a debit, and is the opening balance of the next year, so no reversal is needed.
Calculating the expense
Expense for the year = payments for the year + opening prepayment − closing prepayment
For Moses, Year 2: 30,000 + 4,000 − 5,000 = 29,000, which agrees. Year 1: 24,000 + 0 − 4,000 = 20,000.
Unearned income
The accruals basis applies to income too. The income recognised is the amount that relates to the period, so income may need to be apportioned on a time basis. Unearned income, or income received in advance, arises when, for example, a tenant pays rent in advance. Only the income that relates to the period goes to profit or loss.
The balance is a Liability of the business, because it owes the tenant the use of the property. (For the tenant it is an asset.) The calculation mirrors the one for prepaid expenses:
Income for the year = cash received + opening unearned income − closing unearned income
- Two accounts. Income has been received but part belongs to the next period: Dr Income, Cr Unearned income (a liability). At the start of the next period reverse it: Dr Unearned income, Cr Income.
- One account. The unearned income is carried down as a liability, a credit balance, on the income account. Either calculate the income and take the liability as the balancing figure, or the reverse.
In the statement of financial position, unearned income is a current liability, and prepayments are a current asset.
The ideas in more depth
Mirror images. Accrued expenses and prepaid expenses move the expense in opposite directions. A prepayment lowers this year’s expense and raises next year’s, and accruals do the reverse. For income, accrued income raises this year’s income and unearned income lowers it. A prepayment is an asset. The business has paid for something it has not yet used.
It is not a liability, however large the payment. Unearned income is a liability because the business owes a service. When cash equals the charge. If opening and closing prepayments are equal, the expense equals the payments. Both accruals and prepayments in one account. A rent account may carry a prepayment at the start and an accrual at the end. The formula is applied with the right signs.
Worked example: Lekki Offices
Scenario. Lekki Offices has a 31 December year end. It pays insurance each 1 September: ₦72,000 in Year 1 and ₦84,000 in Year 2. It also rents out space, with rent payable 1 April and 1 October for six months in advance. The annual rent was ₦360,000 to 31 March Year 2, and ₦420,000 a year from 1 April Year 2. Required: the Year 2 insurance expense, and the Year 2 rental income and unearned income.
- Insurance at the end of Year 1.
72,000 × 8/12 = 48,000 prepaid (January to August Year 2). - Insurance at the end of Year 2.
84,000 × 8/12 = 56,000 prepaid. - Year 2 expense.
84,000 + 48,000 − 56,000 = ₦76,000.
Check: 48,000 for January to August plus 84,000 × 4/12 = 28,000 for September to December = 76,000. - Entries. End of Year 1: Dr Prepayments 48,000, Cr Insurance 48,000. Start of Year 2: Dr Insurance 48,000, Cr Prepayments 48,000. End of Year 2: Dr Prepayments 56,000, Cr Insurance 56,000.
- Unearned rent at the end of Year 1.
The 1 October Year 1 receipt of 180,000 covers October to March, so January to March Year 2 is unearned: 180,000 × 3/6 = 90,000. - Unearned rent at the end of Year 2.
The 1 October Year 2 receipt of 210,000 covers October to March: 210,000 × 3/6 = 105,000. - Year 2 rent income.
Cash received: 210,000 + 210,000 = 420,000.
Income = 420,000 + 90,000 − 105,000 = ₦405,000.
Check: 3/12 × 360,000 = 90,000 plus 9/12 × 420,000 = 315,000 gives 405,000. - Statement of financial position. Prepaid insurance ₦56,000 is a current asset and unearned rent ₦105,000 is a current liability.
Common mistakes in the exam
- Calling a prepayment a liability, or unearned income an asset.
- Deducting the opening prepayment instead of adding it.
- Forgetting the reversal with two accounts, or reversing in the one-account method.
- Spreading a payment over the wrong number of months. Count from the date of the payment.
- Using cash received as the income for the year.
- Showing unearned income inside revenue instead of as a liability.
Quick revision
- Prepaid expense: Dr Prepayments, Cr Expense. Current asset.
- Unearned income: Dr Income, Cr Unearned income. Current liability.
- Two accounts: reverse at the start of the year. One account: no reversal.
- Expense = payments + opening prepaid − closing prepaid.
- Income = receipts + opening unearned − closing unearned.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. A prepaid expense is shown in the statement of financial position as a:
- Current liability
- Reserve
- Deduction from capital
- Current asset
Show the answer
D. A prepaid expense is a benefit still to come, so it is a current asset.
Question 2. The entry to create a prepayment with two accounts is:
- Dr Expense, Cr Prepayments
- Dr Bank, Cr Prepayments
- Dr Prepayments, Cr Bank
- Dr Prepayments, Cr Expense
Show the answer
D. A prepayment reduces the expense for the year: Dr Prepayments, Cr Expense.
Question 3. Insurance of ₦36,000 is paid for twelve months from 1 October. The prepayment at 31 December is:
- ₦9,000
- ₦18,000
- ₦27,000
- ₦36,000
Show the answer
C. Nine months remain: 36,000 × 9/12 = 27,000.
Question 4. Payments for rates were ₦120,000. The opening prepayment was ₦24,000 and the closing prepayment ₦30,000. The expense is:
- ₦120,000
- ₦114,000
- ₦126,000
- ₦174,000
Show the answer
B. 120,000 + 24,000 − 30,000 = 114,000.
Question 5. Unearned income is a:
- Current liability
- Current asset
- Expense
- Part of capital
Show the answer
A. The business owes a service.
Question 6. Rent of ₦200,000 is received on 1 July for the year ending 30 June. The unearned income at 31 December is:
- ₦50,000
- ₦200,000
- Nil
- ₦100,000
Show the answer
D. Six months, to June, are unearned.
Question 7. Cash received was ₦480,000, opening unearned income ₦62,000 and closing ₦85,000. Income is:
- ₦457,000
- ₦480,000
- ₦503,000
- ₦627,000
Show the answer
A. 480,000 + 62,000 − 85,000 = 457,000.
Question 8. Payments received in advance from customers are shown in:
- Revenue
- Current assets
- Current liabilities
- Equity
Show the answer
C. Money received in advance is owed in goods or services, so it is a current liability.
Question 9. At the start of the year, with two accounts, a prepayment is:
- Left
- Reversed: Dr Expense, Cr Prepayments
- Reversed: Dr Prepayments, Cr Expense
- Written off to capital
Show the answer
B. At the start of the next year the prepayment is reversed: Dr Expense, Cr Prepayments.
Question 10. Rent paid in advance is a:
- Debit balance on the rent account and a current asset
- Credit balance and a liability
- Revenue item
- Non-current liability
Show the answer
A. It is carried forward as a debit balance.
Section B style: written questions
Question 11 (10 marks). (a) Define a prepayment and unearned income. (4 marks) (b) State the formula for the expense and for the income when there are prepayments and unearned income. (4 marks) (c) State where each appears in the statement of financial position. (2 marks)
Question 12 (20 marks). Garki Traders has a 31 December year end. Rates are paid on 1 April each year: ₦96,000 for the year to 31 March Year 2 and ₦120,000 for the year to 31 March Year 3. In Year 2 advertising income received was ₦480,000, with unearned advertising income of ₦62,000 at the start and ₦85,000 at the end.
(a) Prepare the rates account and the prepayments account by the two-account method, including the reversal. (7 marks) (b) Prepare the rates account by the one-account method. (4 marks) (c) Prepare the advertising income account and the unearned income account. (6 marks) (d) Show the statement of financial position extracts. (3 marks)
A further written question
Question 13 (10 marks). A business with a 31 December year end pays ₦22,500 insurance for the fifteen months starting 1 January Year 2. (a) Calculate the prepayment at 31 December Year 2. (3 marks) (b) Calculate the Year 2 expense. (3 marks) (c) Give the journals. (4 marks)
Model answers
Show the model answer to Question 11
(a) A prepayment is an expense paid in advance that relates to a later period, carried as an asset. Unearned income is income received in advance, carried as a liability. (b) Expense = payments + opening prepayment − closing prepayment. Income = receipts + opening unearned income − closing unearned income. (c) A prepayment is a current asset and unearned income a current liability.
Show the model answer to Question 12
(a)
- Prepayment at the start.
96,000 × 3/12 = 24,000. - At the end.
120,000 × 3/12 = 30,000. - Rates expense.
120,000 + 24,000 − 30,000 = 114,000. - Rates account: Dr Prepayments (reversal) 24,000, Dr Bank 120,000, Cr Prepayments 30,000, Cr Statement of profit or loss 114,000.
- Prepayments account: Dr Rates 30,000 at the end, with the opening 24,000 Dr cleared by the reversal.
(b) One account: Dr Opening balance b/d 24,000, Dr Bank 120,000, Cr Statement of profit or loss 114,000, Cr Closing balance c/d 30,000.
(c)
- Income = 480,000 + 62,000 − 85,000 = 457,000.
- Advertising income account: Dr Unearned income (to carry forward) 85,000, Dr Statement of profit or loss 457,000; Cr Bank 480,000, Cr Unearned income b/d 62,000.
(d) Prepaid rates ₦30,000 in current assets. Unearned income ₦85,000 in current liabilities.
Show the model answer to Question 13
₦22,500 ÷ 15 months = ₦1,500 a month. (a) Three months (January to March Year 3) are prepaid: 3 × 1,500 = ₦4,500. (b) Expense = 12 × 1,500 = ₦18,000, which equals 22,500 − 4,500. (c) Dr Insurance 22,500, Cr Bank 22,500 when paid. At the year end Dr Prepayments 4,500, Cr Insurance 4,500. At the start of the next year Dr Insurance 4,500, Cr Prepayments 4,500.
Pathfinder on Prepaid expenses and unearned income
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Asks for the rent recognised in profit or loss (3 marks) and in the statement of financial position (1 mark) when rent is paid quarterly in advance and then raised, and for a rental income account with accrued and prepaid rent (8 marks).
Revise first: Prepaid expenses
From the previous syllabus. Asks you to show the insurance account for the year, and the charge to profit or loss and the disclosure in the statement of financial position, when insurance is paid each 1 April.
Revise first: Prepaid expenses
From the previous syllabus. The same two tasks with a year end of 30 April: the rent recognised in profit or loss (3 marks) and in the statement of financial position (1 mark), then a rental income account (8 marks).
Revise first: Prepaid expenses
From the previous syllabus. Asks for the rent charged to profit or loss from prepaid rent brought forward, rent paid and accrued rent carried forward.
Revise first: Prepaid expenses
From the previous syllabus. Asks for the prepaid insurance at the year end when a premium covers fifteen months.
Revise first: Prepaid expenses
From the previous syllabus. Both ask how rent paid in advance and rent received in advance are classified.
Revise first: Unearned income
From the previous syllabus. Asks where payments received in advance from customers are included.
Revise first: Unearned income
An item most diets asks for the prepaid amount, the expense or income for the year, or the classification of a prepayment or unearned income. Check Section A of every diet you practise.
Revise first: Prepaid expenses
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2015, November Diet, 2016, May Diet, 2017, November Diet, 2017, November Diet, 2018, May Diet, 2019 and May Diet, 2021 (all previous syllabus). Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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